Many developers of real estate projects involving the rehabilitation of older buildings or historic structures may be overlooking a valuable federal income tax credit that could help defray some of the costs of construction by offering tax credits to the investors.
What is the rehabilitation tax credit and which buildings qualify?
The rehabilitation tax credit is a federal income tax incentive available for the rehabilitation of older or historic, income-producing buildings. Tax credits for historic structures must be certified by the Department of Interior’s National Park Service.
To promote the rehabilitation of such buildings, the credit is:
- Applicable to costs related to the reconstruction costs of buildings, excluding enlargement or new construction; such costs are known as Qualified Rehabilitation Expenditures (QRE’s)
- Based on the age of the building: Certified historic structures qualify for a 20% credit, while buildings first placed in service before 1936 qualify for a 10% credit.
- Claimed in the year the construction is finished and the rentals begin
- Applicable to both landlords and tenants.
What expenses are considered QREs?
Not all expenses associated with a rehabilitation project will be eligible for the credit. Generally, capitalized construction costs will qualify if they relate to:
a. Commercial property
b. Residential real property, but only if it is a certified historic structure
Costs incurred for architectural, design and engineering fees, site survey fees, legal fees, insurance premiums, development fees and other construction-related costs also qualify only if they are included in the capitalized costs of the project.
The tax code also requires that QRE’s meet a “substantial rehabilitation test”. This test is met when the rehabilitation expenditures are complete and rentals exceed the greater of:
a. $ 5,000 or,
b. The acquisition cost of the building prior to the start of renovations
The cost of land is not counted when calculating whether rehabilitation is substantial.
What expenses are not considered a QRE?
Some expenditures are not eligible towards the rehabilitation tax credit including:
a. The acquisition of the building including related settlement costs,
b. The expansion of a building,
c. Parking lots,
d. The rehabilitation of sections of a building leased to or used by tax- exempt persons
What other rules apply to investors and developers?
Investors need to be aware that while the credits may be very advantageous, the credits are subject to the limitations for passive activity losses and credits. Certain rules apply to situations where there is related party debt. There are also some restrictions in the statute and regulations for the credit that include rules for:
1. Depreciation methods
2. Determining a partner or shareholder’s outside tax basis
3. Permitting lessors to pass through the credits to lessees
4. Leasing the property to tax exempt entities
5. Recapture of the credit if the building is not held at least five years
The rules for passing through the credits from a landlord to a tenant can provide developers with another tool in their belt when negotiating leases with their tenants
How to apply for the historic rehabilitation tax credit?
Typically, the process for applying for historic credits starts at the local or state level. A taxpayer must apply to the National Park Service for certification in order to claim the credit. The certification is not only a procedural requirement, but a prerequisite for claiming the credit.
The National Park Service (NPS) works in partnership with the State Historic Preservation Offices (SHPO). A review of the project costs is performed by a state or local historic commission who then makes a recommendation to the Department of the Interior’s National Park Service. For more detailed information, you can visit their website at: https://www.nps.gov/tps/tax-incentives/before-you-apply.htm.
For further guidance on applying for the rehabilitation credit, Friedman LLP can provide you with a thorough understanding of your project and the applicable QREs or help you submit your historic certification application to the NPS. Reach out to your Friedman advisor for assistance.